How to stop corporate scandals: Raise CEO salaries.

How to stop corporate scandals: Raise CEO salaries.

Give That CEO a Pay Raise!

Yesterday, the Senate approved President Bush's proposal to forbid corporations from extending loans to top executives. The measure, almost certain to become law, will come far too late for companies like WorldCom, which has virtually no hope of collecting the $400 million it lent to former CEO Bernard Ebbers. And there's little reason to believe the ban will reduce runaway executive compensation.

But it is sure to have some unintended consequences. Consider what happened the last time Congress played executive compensation consultant: It inadvertently set the table for today's scandals

In the early 1990s, angered by coincident downsizings and reports of large executive payouts, Congress ended the deductibility of executive salaries above $1 million. Before the change, all salaries paid to workers and executives were deductible from a company's taxable income. The new law penalized companies that paid outsized salaries to their top five officers. If General Motors wanted to pay its CEO $5 million, $4 million of that sum would no longer be tax deductible. Assume a 40 percent tax rate for companies (as compensation consultant Pearl Meyer & Partners does) and that $4 million would cost GM an extra $1.6 million.

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But the measure excluded from the $1 million limit items that the Internal Revenue Service deems to be incentive-based or performance-based. As a result, the ban encouraged companies to funnel executive compensation into these murky areas, which are far more difficult for investors and the public to understand, and which are prone to abuse. Indeed, the ban created tax-based incentives for companies to craft some of the pornographic CEO compensation practices that helped get us into the current mess.

Companies like to operate in a tax-efficient manner, which is a euphemism for saying they like to avoid paying taxes. They'll move to Bermuda, hire lobbyists to change the tax code, and shell out vast sums to accountants for advice—all to lower their tax burden.

Companies also like to be tax efficient when crafting compensation plans for their employees generally and for top employees in particular. So, when the new law took effect, CEO base salaries predictably stagnated, because they butted up against the $1 million limit. Between 1996 and 2002, according to Pearl Meyer, the average base salary for CEOs at the top 200 U.S. corporations rose just 15 percent, from $896,385 in 1996 to $1,031,184. But in the same years, alternate types of compensation that received more favorable tax treatments skyrocketed, notably incentive-based payment such as restricted stock, performance bonuses, long-term incentive plans, and stock-option grants. As a result, between 1996 and 2002 overall CEO compensation doubled from $5.8 million to $11.5 million, according to Pearl Meyer. Yet the base salary constituted only 9 percent of CEO pay.

Some of the most richly compensated executives of recent years received base salaries of less than—or exactly—$1 million. At Enron, Jeffrey Skilling's 2000 base salary was a mere $850,000. At Tyco where compensation abuses were rife, only one of the top five officers—alleged tax-dodging ex-CEO Dennis Kozlowski—had a base salary of more than $1 million in 2001. Michael Eisner of Disney has a base salary of exactly $1 million a year. At Citigroup, both Sanford Weill and Robert Rubin take home million-dollar bases. Bernard Ebbers of WorldCom had a base salary of $1 million. A coincidence?

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The base-salary limit has helped cause the enormous problems with incentive-based compensation that plague us today. With the surge in performance-based pay like stock options, as Alan Greenspan put it today, stock options have "perversely created incentives to artificially inflate reported earnings in order to keep stock prices high and rising." It is clear that executives at many companies used aggressive and occasionally illegal accounting methods to protect the source of their greatest compensation: the company's stock price. Scott Sullivan, the WorldCom CFO who allegedly engineered the misallocation of $3.8 billion in costs, received a 2001 salary of $700,000. However, that year he was awarded 619,140 options with an exercise price of $15.62—adding to the 2.6 million options he already held. Their potential value dwarfed his salary.

The rise of incentive-based compensation also provided an easy justification for companies to pay their top executives far more than they ever could if they were simply paying straight salaries. For a large part of the 1990s, bosses could hold their hands up and say, with a straight face, that their salary was merely in the high six figures, and that it was their daring performance that had earned them their untold millions. After all, much of the compensation came in restricted stock and options, whose value could fluctuate with the stock price and was theoretically at risk.

I say theoretically, because companies in recent years have proved ingenious at defining performance in ways that benefited top executives. Stock options were frequently issued far below the market price. Companies began to engineer arrangements by which CEOs would receive a percentage of any increase in net income. When stocks fell, making existing option grants worthless, companies repriced options at lower strike prices or issued new ones at lower prices. As a result, CEOs routinely received substantial "performance-based" bonuses in years where their stocks fell or lagged the broader indices. In 2001, a year when Citigroup's stock stagnated, Sandy Weill received a $16.9 million performance-based bonus. In 2000, Scott Sullivan of WorldCom received a $10 million retention bonus that depended on him "remaining with WorldCom for at least two years after September 2000." For Sullivan, 100 percent of "performance" was just showing up. (Not that he even managed that. Sullivan was bounced from the company for his accounting tricks before the two years ended, and WorldCom is suing to reclaim the cash.)

From the public's perspective, the shift away from cash salaries served to muddy the waters. While base salaries are easily comprehensible, incentive-based compensation packages are frequently opaque. It is difficult for laypeople to determine the value of options and restricted stock. As a result, the media frequently offer conflicting numbers when reporting on executive salaries.

Let's imagine, for a moment, that the $1 million limit was rescinded, and paying cash became the most tax-efficient means of compensating top executives instead of the least. Companies would pursue the path of least tax resistance and pay larger base salaries. And the clarity of a salary, its comprehensibility, its easy comparison with our own, would shine a bright light on executive compensation. It would provide a clear picture of precisely which shareholder resources are being doled out to the bosses. Many companies that currently have no compunction about dishing out options grants worth $50 million would not dare to write $50 million checks to top executives. If Enron had disclosed that it paid Jeffrey Skilling and Kenneth Lay $30 million or $40 million salaries, investors and regulators would likely have raised red flags far earlier. And if Enron cut back on its lavish stock options, Skilling and Lay might not have used accounting trickery to boost the company's share price.